January 26, 2010 8:51 pm
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Hedge funds enjoyed a spectators’ view of the Capitol Hill-Wall Street smashup this month as politicians shined the spotlight of public scrutiny firmly on large banks. But in the clubby world of distressed investing the imminent revision of an obscure element in the bankruptcy code, Rule 2019, has fund managers worried that the hue and cry for full disclosure will rip the lid off their proprietary investment practices.
Those concerns are likely overblown as the impetus to revise 2019 stems from the judiciary’s frustration over its misuse in recent years rather than any public outcry. What’s more, the self regulatory body reviewing the amendment seems averse to accepting the most controversial part of the proposed amendment, a provision forcing investors to reveal when they bought into bankrupt companies and at what price.
“We had received comments specifically focusing on pricing not being relevant,” said Professor Elizabeth Gibson, Reporter to the Advisory Committee on Bankruptcy Rules that will hear testimony 5 February on the amendment of 2019. “So the committee [thinks] it may very well be that the pricing info is not necessary.”
The Rules Committee’s determination about changing 2019 is no academic matter. Hedge funds and corporate executives invoked the bylaw in some of the largest restructurings in the country, ranging from legacy carrier Northwest Airlines, to chemical behemoth LyondellBasell, to Washington Mutual (WaMu) bank to the Six Flags chain of family amusement parks.
Fear that the proposed amendment will smother distressed debt investing has prompted a who’s who of investors and attorneys to apply for testimony at next week’s hearing. As proposed, the change would subject credit derivative swap positions, short positions and holdings in other classes to 2019 disclosure and give courts the discretion to demand price discovery.
Applicants include Abid Qureshi, a partner at Akin Gump involved in the Six Flags bankruptcy; representatives of Angelo, Gordon; Elliot Ganz, general counsel for the Loan Syndications and Trading Association; Thomas Lauria of White & Case and Michael Friedman; Jon Kibbe of Richards Kibbe & Orbe and Judge Robert Gerber of the Southern District of New York.
Even one of the proponents of amending the rule, Judge Gerber, has spoken against including price discovery in the revision of 2019. Judge Gerber stated in a letter to the Rules Committee in January 2009 that pricing is “rarely relevant when making determinations as to the future of a Chapter 11 case.”
Initially intended to enforce transparency about the motivations of stakeholders in Chapter 11, Rule 2019 has increasingly been used as a bullying tactic by debtors and opposing creditor groups. Legal battles involving 2019 proliferated last year amid a spike in default rates, leading to a flurry of contradictory court rulings on the matter.
Those decisions focused on two core issues; first, whether the investors involved constituted an ad-hoc committee, and second, whether they should disclose how much they paid for those holdings. Conflation of those two issues lies at the crux of the controversy as hedge funds often argue that they are not in committees simply to avoid the risk of being forced to bare their investment strategies to the world.
As currently written, Rule 2019 requires members of any group or committee representing more than one creditor or equity holder in a bankruptcy to disclose the amount and nature of their holdings as well as the time of acquisition.
When the rule was originally drafted, trading information about distressed debt was highly opaque and disclosure of time of acquisition did note equate to revealing purchase price. That changed significantly over the past 15 years as increased liquidity coincided with more rigorous reporting requirements in corporate debt markets. Now, even market novices can back into purchase prices of individual bonds, loans and derivative contracts based solely on time of trade.
Until the latest boom of restructurings, the tight knit fraternity of vulture investors and the lawyers who represented them operated under a gentleman’s agreement not to invoke the rule, said one restructuring attorney. Investors and advisors in any given restructuring recognized they would likely encounter each other in future workouts on opposite sides of the table, “so the practice has been to ignore the rule,” the attorney said.
The unspoken arrangement lost traction in recent years as new hedge funds piled into distressed investing even as collateralized loan obligations (CLOs) and pension funds become unwilling participants in corporate restructurings. As the makeup of creditors in bankruptcy became more diffuse, debtors and creditors alike began employing 2019 to threaten creditor groups with competing restructuring plans.
Order in the court
The proliferation of 2019 litigations prompted a series of contradictory rulings, and the recent amendment initiative. “There have been 2019 decisions out of Texas, New York, and now two out of Delaware, and the decisions are not in accord with one another. So it is a very good time to try to reach some clarity,” said a restructuring attorney on background.
In February 2007 when New York State Bankruptcy Court Judge Allan Gropper compelled an ad hoc equity committee in the Northwest Airlines case to disclose under Rule 2019 the amounts, trades dates and prices paid for its positions. Two months later Judge Richard Schmidt of the Southern District of Texas ruled that a group of bond holders in Scotia Pacific’s bankruptcy did not constitute a committee and was not subject to Rule 2019.
Since then, the Great Recession has triggered a surge in restructurings and a consequent proliferation of 2019 litigations. Last February, Judge Gerber compelled bond holders of LyondellBasell to disclose the amount of their bond and CDS positions citing 2019.
More recently, Delaware has become the epicenter of the 2019 debate. In December, Delaware judge Mary Walrath ruled that a group of WaMu note holders constituted a committee and must comply with the disclosure requirements of Rule 2019.
On 8 January, Judge Christopher Sontchi delivered a competing decision refusing a request by one group of creditors to compel a separate group to disclose information under 2019. Two weeks later, a third Delaware judge, Brendan Shannon, ruled that an ad hoc note holder must comply with equity holders’ motion to compel 2019 disclosure.
At the end of the day, most distressed investors would be comfortable submitting their committees to Rule 2019 disclosure as long as that doesn’t include price discovery, said several restructuring attorneys. That includes revealing the timing of their purchases, he added.
The Rules Committee seems sensitive to those concerns. “I understand the point that people have made [in the public comments saying that trade date is equivalent to price] and I’m sure the committee will take that into account as to whether that needs to be adjusted,” Professor Gibson said. ”But it certainly wasn’t intended as ‘okay let’s pretend like we’re not asking for pricing information but we’ll get at it this other way’.”
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